Archive for January 2012

According to an article I saw in Investment News recently, investors were leaving actively managed funds in droves and apparently moving toward passive index funds.

American Funds’ flagship fund, Growth Fund of America, which had peaked at about $202 billion in assets in 2007, lost more than $33 billion last year! No other fund even came close to that. Fidelity Investments’ funds came closest, with net total outflows of $28 billion.

Do investors chase performance, or do outflows affect performance? What many investors don’t know – or maybe they do or are beginning to learn – is that since all investors’ money is pooled together, fund outflows can affect investors who are left behind.

It’s simple logic, really: When a fund declines in value and investors begin selling shares (chasing better performance elsewhere), the fund manager must sell-off positions in order to raise cash in order to meet redemption requests. This can be a problem. Most managers would rather be using cash to buy good companies at reduced prices; but, if they have to meet redemption requests, it hampers investment in potential opportunities! It also works the other way: It’s hard to put new money to work when it’s flowing in at market tops. No wonder indexes seem to do better than the average manager.

American Funds’ Growth Fund of America is a good case in point. Even as it lost $33 billion in outflows, it’s performance in 2011 ranked in the bottom 25th percentile of all large-cap growth funds, although much of the loss can be attributed to holding 18% of assets in foreign stocks, which, according to Morningstar analyst Kevin DcDevitt, is apparently double the category’s average.

Nevertheless, if you subtract the American Funds’ Growth Fund and its $33 billion of outflows from the equation, actively managed funds still trailed passive index funds by nearly $38 billion of net inflows, according to Morningstar data. Exchange-traded funds did even better, collecting $121 billion of inflows.

Who benefitted? Apparently The Vanguard Group! They took in $29.5 billion in mutual fund inflows last year, the most of any mutual fund family. American Funds family lost $81.5 billion.

Whether investing inside or outside of a tax-deferred retirement account, investors are wise to keep a sharp eye on costs. It’s true that cost is a function of value – no one minds paying for value – but, it’s important not to pay excessively and to know what you’re paying for.

Paying attention to share classes is a beginning. If your funds have 12b-1 fees, the question has to be “Why?” Is an alternative arrangement with greater transparency available?

Due-diligence begins at home.

Jim

Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Retirement plan participants will soon find out how much they’re really paying for their retirement plan; but, there’s more to the story.

While I have faith that many service providers will go to great lengths to find a way to make the disclosures confusing – there is a lot of money at stake – some will be more transparent. Either way, it won’t be long before word gets out on what to look for; after all, people do talk to each other and it won’t be long before someone gets it.

Here’s an oversimplified but excellent example:

There are three basic functions to running a retirement plan. In no particular order, they are:

Investment advisory and management – The advisor to the plan and the investment managers, in most cases mutual fund companies.

Often, usually in ‘bundled’ solutions, all three are paid from a bundled fee to a package provider based on assets under management in the plan. Why a package provider – and the additional compensation required for them – is necessary, I haven’t figured out yet.

I can understand any entity having an impact on investment (and investor) performance having compensation tied to asset value; that’s shouldn’t be a potential problem. The problem will likely come when plan participants begin thinking about – or someone tells them – about #2 and #3.

Recordkeeping and administration are ministerial activities. They’re administrative functions that have no impact on, or connection to, the investment, or investor’s, performance.

Think about it: If two companies each have 100 employees, it costs just as much to file a form or credit a deposit for a participant in a $3M plan as it does in a $15M plan. Why should the $15M plan pay five times as much for the same service?

How about two participants in the same plan? It wouldn’t be surprising to find them comparing statements only to find out that one is paying twice as much as another for the same administrative function – one that has nothing to do with their investments.

That’s when they’ll start knocking on the door of the CFO or the HR director asking, “Why am I paying twice what she is simply to process a withdrawal?”

Hamina, hamina, hamina…..

“…. and I have another question…..”

Plan sponsor fiduciaries will have to be ready with the right answers.

Jim

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Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

If you are someone who makes decisions regarding your company’s retirement plan, this could be quite important for you to know.

I entered the advisory business in 1990, coming from the world of management consulting; so, I was used to a business model where the consultant works for the client and is paid on a pure fee basis. The way you kept clients was by bringing value to the client beyond the size of the fee charged and by avoiding interest conflicts – a standard beyond merely ‘disclosing’ them.

What I wasn’t used to was the marketing hype used to sell the products and services in the advisory industry, as opposed to the management consulting industry. Let’s face it: The advisory industry certainly has its share, always built around whatever is currently happening in the marketplace.

These days, especially with new disclosure rules coming down the pike, plan sponsor fiduciaries are rightly concerned with minimizing liability exposure and, of course, there are advisors now jumping out of the bushes telling plan sponsors how they can virtually eliminate their liability for investment management. All they have to do is hire a 3(38) investment manager instead of a 3(21) advisor. By the way, an advisor can be either a 3(38) or a 3(21), it’s simply a matter of taking discretion and meeting a few other requirements; so, why wouldn’t all advisors get on the band wagon?

The fact is, many are jumping on board; but, like all marketing fads, this one may prove to be little more than a smoke screen, after all.

Now, I’m not an attorney, let alone an ERISA specialist; but, I did study enough law to know that the doctrine of constructive knowledge doesn’t refer to the building of an overpass, and it helps that I can get ERISA attorneys on the phone.

With those limitations in mind, here is my own humble take on the 3(38) vs. 3(21) discussion.

First, the 3(21): ANY individual is a fiduciary under Section 3(21) if he or she exercises any authority or control over the management of the plan or the management or disposition of its assets; if he or renders investment advice for a fee (or has any authority or responsibility to do so); or if he or she has any discretionary responsibility in the administration of the retirement plan, not to be confused with the ministerial duties of a third party administrator.

The point: It’s a functional test; it’s not about titles. If YOU make any decisions regarding your plan, YOU are functioning as a 3(21) fiduciary. If you think it’s a good idea to get professional help, you can hire a 3(21) consulting professional to become a co-fiduciary to help you perform your duties. The ERISA regulations even appear to encourage this and will allow you to pay the consulting professional from plan assets, something many company plan sponsors appreciate. Included among a fiduciary’s responsibilities is the prudent screening, selection, and monitoring of plan investments (and managers), including establishing and following a documented prudent process for the selection, review, and possible replacement of the investments or managers. This includes documenting a decision not to replace investments or managers; and, by the way, doing nothing is a decision that should be documented. So much for our cursory description of a 3(21).

What’s a 3(38) manager? ERISA section 3(38) defines “investment manager” as a fiduciary due to their responsibility to manage the plan’s assets. ERISA provides that a plan sponsor can delegate the responsibility (and thus, likely the liability) of selecting, monitoring and replacing investments to a 3(38) investment manager/fiduciary. A 3(38) fiduciary may only be a bank, an insurance company, or a registered investment adviser (RIA) subject to the Investment Advisers Act of 1940.

So, is the plan sponsor ‘off the hook’? You need only review the plan fiduciary’s responsibilities: The plan sponsor is acting – remember, it’s a functional test – as a 3(21) when they make ANY decision regarding the plan. Selecting a 3(38) manager is a 3(21) function, don’t you think? Monitoring and possibly replacing the 3(38), including documenting your actions or inactions, is also a 3(21) function! If that makes sense to you – and it should – then it will be easy to follow this logic:

The 3(21) plan fiduciaries are relieved of investment related management decisions of the 3(38), provided the 3(21) fulfills his/her fiduciary responsibilities, a few of which I outlined earlier.

Failure to fulfill fiduciary responsibilities by a 3(21) could likely result in a loss of those protections afforded by the 3(38).

You can’t escape it: You still have the obligation to perform your 3(21) responsibilities, or hire a professional to help, which can make the process a lot easier and likely more thorough. You still need a 3(21) to provide oversight of the 3(38).

The 3(38) manager can relieve you of investment related liability (see #1 and 2), but is now actually functioning as another service provider. To conclude that the 3(38) manager’s reporting fulfills your oversight requirement might be somewhat naïve. Whoever heard of fulfilling a fiduciary obligation to monitor a service provider by allowing them to monitor themselves? (Note: Just as many advisors are now jumping on the 3(38) bandwagon and promoting the `elimination’ of fiduciary liability, those same advisors are marketing their services to 3(21) advisors in hopes of getting plan takeovers… “We can remove liability, etc.”).

The Bottom-Line:

Plan sponsors are still responsible for the selection, monitoring, and possibly replacing the 3(38) advisor who, after all, may be held to be little more than a vendor selling an investment service but responsible for their own actions. Failure to follow a prudent process in doing this just might result in a loss of the protections. To me, that logic is pretty clear to see. The short takeaway: You’ll probably still need a 3(21) on your side of the table to conduct due-diligence on the 3(38) manager, who should be regarded as another service provider, albeit with increased responsibilities.

Be safe: Talk to your ERISA attorney.

Jim

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Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Most investors are unaware of many of the costs they pay to own investments. This is particularly true of mutual fund investors simply because some costs aren’t disclosed… and those charges can be significant!

Take portfolio turnover for example. The turnover ratio is disclosed in fund prospectuses; but, few investors know what they’re looking at even when they see it!

The turnover rate in a fund is not necessarily a bad thing, but it does increase your tax bill if the fund is selling stocks with lots of short-term gains; and that turnover means additional hidden costs… costs that come out of your return.

If turnover does hurt a fund’s return, wouldn’t there be a correlation between a fund’s turnover rate and its after-tax return? In many cases there is.[1]

Turnover is an important factor in determining a fund’s true costs. For example: When a fund manager makes a trade on an exchange, that trade incurs a commission – just like your own trade would – and the fund manager receives a `confirm’ reflecting the net proceeds of the trade AFTER commissions have been taken.

Why use the 2.2 factor for a 120% turnover? Simple: You have to `establish’ a position in a security before you can turn it over; and, that’s true for each security in the portfolio. The entire portfolio is established, then 120% is `turned over’ in a year.

You should add this figure (1.32% in our example above) to the fund’s annual expense ratio to get combined annual expenses plus trading costs. According to Morningstar, the typical equity fund has annual expenses of 1.4% annually. 1.32% in trading costs plus the 1.40% annual expense ratio gives a total of 2.72% in true costs.

Are we done? Nope.

There are also `market impact costs’ to consider. What’s market impact?

When you or I sell 100 shares of a security, it doesn’t really impact the price. But, when an institutional investor buys or sells huge blocks of a security, the price can be affected. How much? According to Business Week magazine (4/3/2000), market impact costs can range between 0.15-0.25%!

You guessed it: The market impact of each trade is multiplied by turnover, too. So, using the low-end market impact cost in our hypothetical, we’ll apply the turnover factor: 0.15% x 2.2 = 0.33%. Add the 0.33% to our 2.72% and we can estimate the true costs (disclosed and hidden) of our fund.

So our hypothetical fund with a 1.4% annual expense ratio that experiences a 120% annual turnover could actually be costing the shareholder 3.03% annually, quite a bit more than the 1.40% expense ratio disclosed in the prospectus. Hmmm.

Is that bad? It depends! Some managers may be worth an extra 3.05%. Some aren’t worth a penny. Few, if any, can consistently outperform their own index. And, knowing how to do the math is important.

Think about it. For a manager to tie an index that went up 10%, for example, the manager would have had to achieve a 13.05% return! You may think that’s only 3.05% over the index, but you’d be wrong. 3.05% over 10.00% is actually outperforming the market by 30.5%! No wonder so few managers outperform and virtually none can do it consistently.

It’s like anything else: Value is relative. But, it’s too bad that most investors see only the annual expense ratio and assume it’s everything they pay. As you can see from this hypothetical yet realistic example, disclosed annual expenses can actually be less than half of the total investors really pay!

That’s not all. Go pull out your last mutual fund statement that you received. I’ll wait. Read it carefully. Do you see any of your expenses and fees enumerated in dollar terms? ANYWHERE?

No fee deductions anywhere at all? Do you suppose it’s free?

Of course not. They just adjusted the fund price – the NAV – after the deduction of all costs and expenses so your costs are `hidden’ in the price of the shares.

Interesting, huh?

Jim

[1] During the past decade, for example, the highest-turnover quartile of funds (165% annually) provided an annual pre-tax return of just 9.8 percent, while the lowest-turnover quartile (13%) returned 11.5%, an advantage of 1.7% per year—a cumulative extra profit of nearly 30%. What is more, the high-turnover quartile of funds took nearly 30% more risk (standard deviation of 20.6% vs. 16.2 percent). John Bogle, Ex Chairman, Vanguard Fund 4/12/06. And turnover also increases taxes (short-term gains are taxed at 35%, long-term at 15%) leading to this conclusion by Lipper: Taxable investors owned approximately half of the $8.391 trillion invested in open-end mutual funds, and on average over the last 10 years gave up on an annual basis 1.6 percentage points to 2.4 percentage points in return because of taxes. Taxable equity and fixed income funds shareholders surrendered over 20% and approximately 45% of their load-adjusted returns because of taxes, respectively. Source: Taxes in the Mutual Fund Industry 2006, Lipper.

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Jim Lorenzen is a Certified Financial Planner® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

Yield can be a poor evaluator when comparing bond mutual funds, simply because there is no maturity date.

You see, individual bonds have a maturity date. Regardless of interim price swings, bonds are designed to mature at face value. So, if you own a 5-year bond with a face value of $10,000, it will mature at $10,000 regardless of the interim price swings.

Not so with bond funds. They have no maturity date. When you own a bond fund, your money is pooled with other investors in an actively traded portfolio. As a result, bond mutual funds can appear to have nice yields, but can still lose a significant portion of value from even a slight interest rate increase in the bond marketplace. The reason is simple, when interest rates increase, existing lower rate bonds aren’t as attractive and their prices must be reduced if they are to attractive to potential purchasers. So, it’s not much comfort to see an extra point in advertised yield only to see a larger percentage loss in principal if interest rates increase.

When investing, the concept worth remembering – one which many overlook – is ‘total return’. Total return is a combination of yield (dividends, interest, etc.) plus change in value.

Yield + Change in Value = Total Return

For investors still accumulating assets, portfolio appreciation is achieved primarily through long-term growth, which generally occurs in the equity (stock) portion of the portfolio. Bonds simply aren’t designed for growth objectives.

Bonds, however, can help achieve other objectives: Income, portfolio risk management, predictability.

Bond funds can serve as effective tools for portfolio diversification and risk management simply because (1) they represent a different asset class from stocks, and (2) their ease when it comes to portfolio rebalancing. Individual bonds aren’t as easy to use when it comes to rebalancing. There’s an old saying in the bond market: Buyers buy the market and sellers pay the freight.

On the other hand, individual bonds may be worthwhile for income or predictability objectives. Just as many people are used to `laddering’ CDs, the same can be done with bond. The fact that individual bonds have maturity dates also adds to predictability.

As you are probably aware, interest rates and bond yields are terribly low these days, so many investors have a tendency to `shop’ for the highest yields they can find. The thing to remember is that all bond managers shop for bonds in the same bond market. When they increase yield, they’re generally sacrificing portfolio stability.

There are only two ways to add yield; they are (1) buy lower-quality, or (2) buy longer maturities, both of which add to volatility risk. I’ll never forget someone fifteen years ago saying to me, “I didn’t know you could lose money in a long-term U.S. Government bond fund.” I think he lost around 20% of his original investment, but he did save 1% in advisory fees. He didn’t realize that in order to add stability, he needed to limit maturities and stress quality – it also helps to have a maturity date as a backstop.

Fund turnover is important too. They bring hidden costs, but we’ll talk about that tomorrow.

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.

If your company is a plan sponsor providing a retirement plan for your employees and you are someone who makes decisions regarding your plan, you should realize that choosing investments, or even approving the choices, is a fiduciary act. This is serious business and. as any ERISA attorney will tell you, can result in personal liability for your decisions. You should talk with your ERISA attorney – not your provider’s.

Offering company stock within a 401(k) plan enables participants to share in the success of the plan sponsor and can help further an ownership culture. However, offering company stock also can increase the liability exposure for plan fiduciaries. While there are ways to mitigate this risk, most fiduciaries are not taking those steps and as a result are potentially increasing exposure to litigation thereby potentially endangering their personal assets.

This liability potentially extends beyond the Plan Committee members to the Board of Directors and even to the CEO. Remember that a fiduciary must act solely in the interest of the plan participants, their beneficiaries and alternate payees. While an in-house fiduciary can legally perform this role, it is laden with pitfalls. When evaluating company stock in a plan, a fiduciary cannot be influenced by virtue of their role with the company. Of particular concern is any access, whether actual or inferred, to material nonpublic information.

Fiduciary duties that apply to company stock in a 401(k) plan

Fiduciaries are required to carry out their duties in a prudent manner, which includes giving “appropriate consideration,” especially with respect to the terms of the plan, to the facts and circumstances that they know or should know are relevant to the investment or investment course of action involved.

Fiduciaries must act solely in the interests of plan participants, even if participants’ interests may be contrary to those of the fiduciary.

In contrast to other plan investments, investments in company stock are exempt from the requirement to diversify plan assets, as well as from the duty of prudence to the extent that it requires diversification. However, a fiduciary could be required to liquidate investments in company stock if they determined that this investment was contrary to ERISA, principally in dire circumstances.

Managing the increased liability exposure with company stock

Reviewcompany stock practices with a qualified ERISA attorney.

Hire an independent third party fiduciary and invest in them the exclusive discretion to take action, on behalf of the plan, in regards to the retention or divestiture of company stock.

Remove any restrictions regarding participant sale or diversification of company stock.

Consider amending the relevant plan documents to require that the plan offer company stock as an available investment option, with additional language included in the plan documents (engage ERISA counsel for assistance with this step).

Consider making company stock an ESOP (KSOP) within your 401(k) plan.

Comply with all 404(c) requirements.

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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® and an Accredited Investment Fiduciary® in his 20th year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. IFG provides investment and fiduciary consulting to retirement plan sponsors and selected individual investors. Plan sponsors can sign-up for Retirement Plan Insights here. IFG does not sell products, earn commissions, or accept any third-party compensation or incentives of any description. Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.